Most people know what it means to borrow and lend money, whether it's for a mortgage, a student loan, or something else. In fact, it is one of the most important parts of how finance works. Lenders give money to borrowers with the expectation that they will pay back the amount plus interest. In exchange, the borrower gets access to money right away.
DeFi shed light on how the financial market for lending and borrowing could work in the digital world. Traditional financial markets have been playing a critical role in the global economy since the industrial age. They rely on trusted third parties as middlemen to give loans based on credit. Even though the internet has changed the rest of the world, it didn’t change much about how we lend and borrow assets in this financial system, until DeFi was born.
Decentralized finance (DeFi) is different. It gives people a way to keep their own assets and earn interest on them at the same time. Using smart contracts on a blockchain, users can choose which money market to lend to and earn interest from based on the market's current lending rate.
These DeFi lending markets are open to everyone, and you don't need to share your personal information like your credit score or do KYC to use them. To the DeFi users, this is an easier way to handle money than traditional banks. Decentralized applications allow people who don't have bank accounts, can't get loans, or can't open bank accounts to access the new form of financial markets.
Also Read: Learn the basics of DeFi
Users who want to lend their tokens and earn a lending yield send their assets to a DeFi "money market." This is done when the smart contract of the platform handles the transactions at the background and acts as an automated digital middleman. After this, the coins are available for borrowing by other users.
The "money market" then pays interest from the interest the platform collects through lending the assets out to the borrowers.
Almost all loans underwritten by DeFi lending markets are overcollateralized. This means that users who want to borrow money have to put up a guarantee in the form of crypto that is worth more than the loan itself.
Even though this might seem counterintuitive on paper since the borrower could just sell their assets to get the money in the first place, there are many good reasons to borrow from DeFi.
First of all, borrowers may not want to sell their assets because they may go up in value in the future; instead, they can use the assets they hold as collateral to borrow a different asset, eg a stablecoin to pay for expenses. Similarly, with various yield opportunities in DeFi, users can have access to different assets by using a money market instead of actively trading. Lastly, traders oftentimes use money markets for leveraged trading.
In traditional lending, a borrower may have to put up collateral to get a loan. A house, for instance, serves as collateral for a mortgage. In the event of a default by the borrower, the lender seizes possession. It's referred to as a secured loan. Unsecured loans is xxxx. Lenders don't ask for collateral for loans, like credit card debt, or they only ask for partial collateral. Because the lender is at greater risk because they have no collateral at their procession in the event of a default, interest rates are often higher for unsecured loans.
Users who want to borrow money through DeFi must put up cryptocurrency collateral in the form of tokens that are worth more than the loan itself. The collateral is under the custody of the smart contract until the loan is paid back.
DeFi loans also have no time restrictions on how long you can borrow money for. The loan can go on for as long as the value of the collateral is higher than the value of the money plus the interest that was accrued. But if the value of the collateral drops below a predetermined liquidation threshold, the smart contract starts an automatic collateral liquidation.
Also Read: DeFi in the Cosmos Ecosystem
This article discusses the potential for DeFi to transform the whole financial system. Primary services in the traditional financial world like payments, trade, investing, insurance, lending, and borrowing all have the potential of transforming into a native DeFi form. With the adoption of blockchain and smart contract technology, DeFi has the potential to reshape the world of finance.